Can anyone explain to me exactly what financial derivatives are and why so many people refer to them as if they're demons or something? I'm sure this is a dumb question, but I'm trying to learn more about economics. I think I understand what they are, but I'm not sure even though I've looked in many other places. Thank you.
A derivative is an asset that derives its value from another asset. For example, a call option derives its value from a value of an underlying stock. A call option gives you a right to purchase a particular stock at a certain price. Let's say stock A is trading at $40. And there is a call option that gives you a right to purchase stock A for $30. Automatically, the market will push the value of that call option to at least $10, so that when you buy that call option and exercise it (meaning you buy a stock for 30 and then sell it at 40) you make $10 (40-30), which exactly offsets the price you paid to obtain the call option. Most likely the call option would trade slightly above $10 since there is an expectation that stock A might rise. Now, if the price of stock A rises to $50 the market will push up the value of the call option to at least $20. Basically, the call option derives its value from the underlying stock value.
Regarding stocks, there is also a put option, which gives you a right to sell a stock to an investor at a price specified in the contract. You basically make money with the put option when the stock price falls since you can then buy the stock at a lower price on the open market and sell it through your put option to an investor at a higher price.
Derivatives can be very useful to minimize risks. For example, people holding BP stock during the oil spill could have bought a put option to insure themselves in case BP went bankrupt. Also, a lot of farmers use commodity derivatives to avoid fluctuations in their profits due to sudden changes in agricultural commodity prices. Businesses that trade abroad can use forward contracts (right to buy or sell a currency at a specified rate in the future) to eliminate fluctuations in their profits due to changes in foreign currency markets.
Everybody is demonizing derivatives related to the housing market. One of these infamous derivatives is a mortgage-based-security (MBS). A mortgage-based-security is basically a bundle of different mortgages, so it bases its value on the value of underlying mortgages. On the other hand, mortgages base their value on the ability of borrowers to repay the sum they borrowed plus the interest,. In case they defaults, the value of mortgages is then based on the value of the houses borrowers bought (collateral). If borrowers cannot repay and the value of the houses declines in the meantime, the value of the MBS will decline also. With the bursting of the housing bubble, borrowers defaulted, the glut of houses on the market pushed the housing prices down, which eroded the value of mortgage-based-securities.
Another infamous derivative is a credit default swap (CDS) or credit default obligation (CDO)... I think these are the same but I could be wrong. Basically, a CDO is like an insurance policy. You are betting that somebody is going to default on their debt. You are paying a steam of premiums to a person or institution insuring you. In case the borrower defaults on debt, you get paid by the insurance company a lump sum. Let's say you lend money to a person A. Then you can go to person B and ask him to insure that debt. In return you are paying him a stream of premiums. In case person A defaults on his debt, person B will pay you a lump sum. This way you can minimize your risk of lending to A. The interesting thing about CDOs is that you don't have to be a holder of a debt to buy a CDO. So let's say C lends money to A, well you can still purchase CDO from B betting that A will default. CDOs are infamous because they brought AIG down. Basically, AIG was issuing CDOs on all these MBS-s. CDOs based their value on the value of debt they insure. In this case it were all these MBS-s. Since MBS-s were highly rated, people buying CDOs didn't have to pay high premiums to AIG. When the collapse came and MBS-s became worthless, AIG didn't have enough money to pay out the claims since it didn't collect enough in premiums. An analogy would be insuring people in Montana against earthquake. Since earthquakes are very rare in Montana (I could be wrong about this lol), the premiums people have to pay are going to be low. Well, let's say there is all of a sudden this huge earthquake, which destroys all the insured houses. Since the insuring company didn't collect enough in premiums, it has to default on paying out claims.
I hope this helps. Sorry, it is really lengthy
I am a fresh upstart derivatives trader, and I have broken even on all my trades so far, so I can help. :)
A derivative is a contract based on another underlying asset.
Both the trading of assets and trading of derivatives based on them help establish prices for the assets.
eg. Gold is a commodity. An agreement to buy gold in three months at a certain price is a derivative on gold. Euro is a commodity. An agreement to have the right to buy 1 Euro for $100 next year is a derivative on Euros.
Derivatives are mainly futures (where you agree that you MUST buy or sell something at a specified price in future), options (where you agree that you MAY buy something at a specified price in future), options on futures, options on options, and swaps (where you "borrow" money from somebody, and "lend" it back to him, and then exchange interest on a purely notional principal).
Over the counter derivatives are demonized, because they are not exchange traded and are done without existing regulation or procedure other than direct phone calls. Some OTC derivatives like synthetic CDOs (explained here) are seen as being so funky that they might be outright gambling and a misuse of depositor's money.
Another infamous derivative is a credit default swap (CDS) or credit default obligation (CDO)... I think these are the same but I could be wrong.
They are not the same, and there is more than one kind of CDO.
Oh, I don't know how I forgot this thing.... politicians hate credit defauly swaps (CDS) because it shows how much they are financially irresponsible. The Greek crises is the best example. Basically, when bond vigilantes became aware of Greece's enormous debt and continuting fiscal irresponsibility, they jacked up the interest rates on the Greek bonds This is reasonable since the risk of Greece defaulting became higher. So in effect interest rates served as signal to warn other market participants of Greece's fiscal problems. In addition to interest rates, credit default swaps serve as a market signal as well. As the risk of Greece defaulting increased, so the the level of premiums you had to pay to an insurance company to insure against the Greek debt increased. As investors stareted picking up these signals, soon the problems of other countries became evident. Consequently, interest rates and premiums on insuring against bonds of these other countries increased. Politicans hate when the market tells them that they are acting irresponsibly and that they need to stop spending. If you google the news articles around that time, you can see how Angela Merkel and Sarkozy were just demonizing CDS and bond vigilantes.
Sanjay,
as my understanding goes, CDS is a premium you pay for insuring against governmental bonds. Am I wrong? Could you please go into the differences between CDO and CDS and explain different CDOs if you don't mind? Thanks
A CDO is a collaterized debt obligation... it is basically a pool of loans. For example, car companies might pool together a bunch of auto loans into a basket and sell of shares in that pool to investors. A mortgaged backed security, which is slightly different in structure, is basically a CDO - related to mortgages. In reality a CDO can be made out of any sort of loan. The assets in these cases (cars, houses, etc.) serve as the collateral, hence the name.
A CDS is a credit default swap. Which is basically insurance on the chance that a debt insturment that you are holding will default. Unlike regular insurance, however, you don't have to hold the underlying secutiy in order to hold the insurance contract. They can be sold separately from each other. So I can own a CDS on GM that will pay out if GM defaults on its bonds, even if I don't own GM bonds.
Hope thats helpful.
At least he wasn't a Keynesian!
Slobodan, I gave a link at the end of my post to another post I made where I explain credit default swaps, asset backed securities, cash credit default obligations, and synthetic credit default obligations.
oh sorry, my computer didn't show your post. btw, could u recommend me some books on technical analysis? thanks